Question

The Alto Horns Corp. is planning on introducing a new line of clarinets. They expected EBIT is $900,000. The unlevered cost of equity is 15%. The firm plans to raise $1,000,000 as a 10% interest perpetual debt. Assume depreciation, net working capital, and investment cash flows are 0. The corporate tax rate is 20%. Which of the following represents the correct annual cash flows to be used under the WACC method?
a. 490000
b. 640000
c. 420000
d. 600000
e. 525000

Answer 1

Answer:

The correct option is B,correct annual cash flows to be used under WACC method is $640,000

Explanation:

Expected earnings before interest and tax is $900,000

interest expense on the 10% interest perpetual debt=10%*$1000,000=$100,000

earnings before tax=EBIT- interest expense=$900,000-$100,000=$800,000

earnings after tax=earnings before tax-tax expense

tax expense=earnings before tax*20%=$800,000*20%=$160,000

earnings after tax=$800,000-$160,000=$640,000

The correct amount of annual cash flow to be used under weighted average cost of capital method is $640,000 which after interest on debt and taxes have been deducted.